FormFactor Inc

NASDAQ:FORM

Earnings Call Transcript 2021-Q3

[Operator]

Thank you, and welcome, everyone, to FormFactor's Third Quarter 2021 Earnings Conference Call. On today's call are Chief Executive Officer, Mike Slessor; and Chief Financial Officer, Shai Shahar.

Before we begin, Jason Cohen, the company's General Counsel, will remind you of some important information.

[Jason Cohen, General Counsel, Investor Relations]

Thank you. Today, the company will be discussing GAAP P&L results and some important non-GAAP results intended to supplement your understanding of the company's financials. Reconciliations of GAAP to non-GAAP measures and other information are available in the press release issued today by the company and on the Investor Relations section of our website. Today's discussion contains forward-looking statements within the meaning of the federal securities laws.

Examples of such forward-looking statements include those regarding projections of financial and business performance, future macroeconomic conditions, the benefit of acquisitions and investments in capacity and in new technologies, the impacts of COVID-19 pandemic, our supply chain, the impacts of regulatory changes; the anticipated demand for products; our ability to develop, produce and sell products, and the assumptions upon which such statements are based. These statements are subject to known and unknown risks and uncertainties that could cause actual results to differ materially from those expressed during this call. Information on risk factors and uncertainties is contained in our most recent filing on Form 10-K with the SEC for the fiscal year ended 2020 and in our other SEC filings, which are available on the SEC's website at www.sec.gov and in our press release issued today. Forward-looking statements are made as of today, October 27, 2021, and we assume no obligation to update them.

With that, we will now turn the call over to FormFactor's CEO, Mike Slessor.

[Mike Slessor, President and Chief Executive Officer]

Thanks Jason, and thank you everyone for joining us today. FormFactor delivered solid results in the third quarter again recording the second highest revenue in company history with gross margins at the highest of our [Indiscernible]. Together with sustained operating expense control, these factors resulted in non-GAAP earnings per share above the high end of our outlook range. We continue to benefit from strong demand FormFactor's diversified set of market leading semiconductor tested measurement products. And with our added production capacity now coming online, we're well positioned in the current quarter to deliver sequential growth.

Like many companies in the semiconductor industry, we're facing a variety of supply chain and labor challenges. Our long-term investments in automation and vertical integration has helped reduce the effect of these headwinds. And we've thus far success navigated these issues with minimal impact. We do expect this situation to persist into next year, and our team remains focused on actively resolving these challenges. Minimizing impact where supply chain is especially important as our capacity investments start coming online. Tool installations and qualifications are now underway in our new Livermore Manufacturing Center, which remains on track to deliver initial customer shipments in the current quarter. We're excited to be on the cusp of commissioning this new flagship facility, which will remove a growth constraint we've operated under for almost two years, helping us to reach the $850 million revenue of our target financial model.

I'd like to provide some detail behind our sequential improvement in gross margins, as it provides insight into the importance of the design specific product mix within each of our served markets. As you can see from the supplemental materials posted on our website, and as Shai will review later, third quarter revenue by segment end market was very similar to the second quarter, yet we delivered 160 basis point improvement in gross margins. The largest single factor in this improvement was a more favorable product mix within the specific markets. As we've noted in the past, probe cards are consumable specific to each customer chip design, and the custom nature of each probe card design drives a different manufacturing cost and selling price. For example, two DRAM probe cards configured to test two different customer chip designs can produce significantly different gross margins because of the details of the probe card and tester configuration, like the difference between a one touchdown configuration versus a two touchdown configuration.

Consequently, two quarters with similar revenues and each segments and market can and often do result in substantially different gross margins depending on the specific probe card shift to produce that revenue. This variability is inherent to FormFactor's broadly diversified design specific consumables business, and since we serve major applications at all the leading customers in the semiconductor industry, delivering probe cards to test hundreds of different chip designs each month, we expect to continue to see quarterly fluctuations of gross margin around the long-term trend line expanding to the 47% of our target financial model.

Turning now to segments and market level details. Foundry & Logic probe cards, our largest business performed at levels in the third quarter comparable to the second quarter, with an expected seasonal reduction in mobile application processor demand, offset by an increase in microprocessor demand and sustained strong growth in 5G RF applications. With 2021 large foundry and logic wafer fab equipment investments now coming online at our customers, we're experiencing increasing demand for leading edge foundry and logic probe cards. Along with their capacity additions, our customers are adding Innovative Advanced packaging architectures like EMIV, [Phobos] and 3D fabric to the roadmaps to help offset the slowing of front end driven Moore's law. As we discussed in the past, these chiplet or tile based integration schemes drive both higher test intensity, which expands the number of probe cards required per wafer out and test complexity, which widens FormFactor's competitive advantage.

With lead times of less than a quarter, short term visibility remains challenging as always, with the combination of significant customer capacity increases. Paired with their adoption of advanced packaging creates long-term demand for FormFactor's probe cards products. Demand for DRAM probe cards in the third quarter sustained near the high levels of the second quarter, and we expect comparable strength in the current quarter. As in foundry and logic, we experienced demand shifts between different customers and different chip designs across multiple DDR4r and DDR5 designs in both mobile and PC server applications. FormFactor's ability to absorb these short-term fluctuations in demand from any one customer is the result of our long-term initiatives to be a diversified market leader supplying all major DRAM manufacturers and remains a key tenant of our operational strategy in all of our served markets.

Our engineering systems business also delivered good results in the third quarter with gross margins at 50% for the first time since early 2020. A highlight of the quarter was the shipment and installation of multiple FRT high performance multi sensor 300 millimeter optical metrology tools to a single foundry customer for enhanced packaging applications. Advanced packaging is a key driver for all FormFactor's businesses as our customers begin to adopt chiplet tile integration strategies to generate new test and measurement requirements. The FRT tools ability to quickly accurately and non destructively measure and control critical dimensions, film thicknesses and surface topologies on chiplet to chiplet interfaces is key to improving and maintaining advanced packaging assembly yields.

Let me close by noting that with an accelerating demand outlook, increased capacity to meet that demand and good execution on both short and long-term gross margin improvements. We're well on the path to the target financial model we unveiled last year that delivers $2 of non-GAAP earnings per share on $850 million of revenue. Test and measurement is clearly gaining importance in the semiconductor industry, driven by powerful trends including 5G, advanced packaging and memory content growth. Our leadership position in these attractive markets, paired with our differentiated strategy and disciplined execution will drive continued growth and share gains as we progress towards our target model. Shai, over to you.

[Shai Shahar, Chief Financial Officer]

Thank you, Mike and good afternoon. As you saw in our press release, and as Mike mentioned, third quarter revenues and non-GAAP gross margins were at the high end of our output range, with revenues again reaching the second highest level in company history. And non-GAAP EPS exceeded value and were out of range. FormFactor's third quarter revenues were $190 million, a 1% sequential increase in Q2, and an increase of 6.7% year-over-year. Probe cards segment revenues were $155 million in the third quarter, a small increase of $1.2 million or 0.8%. from Q2. As Mike mentioned, third quarter revenue by segment end market was very similar to the second quarter. System segment revenues was $35.1 billion in Q3, an increase of $0.7 billion, or 2% from the second quarter, mainly as a result of higher sales of optical metrology and thermal systems driven by advanced packaging and automotive applications.

Within the probe cards segment, foundry and logic revenues increased by $1 million from Q2 to $105 million in the third quarter, comprising 55% of total company revenues, same as in the second quarter. DRAM revenues were $40 million in Q3, a decrease of $2 million or 5.5% in the second quarter, and were 21% of total quarterly revenues as compared to 22% of revenue in the second quarter. Flash revenues of $10 million in Q3 were $2.5 million higher than the second quarter, and were 6% of total revenues in Q3, up from 4% in Q2. As we have said in the past, we expect Flash revenues to be lumpy from quarter-to-quarter.

GAAP gross margin for the third quarter was 42.2% of revenues as compared to 40.6% in Q2. Cost of revenues included $7.2 million of GAAP to non-GAAP reconciling items, which we outlined in our press release issued today and in the reconciliation table available in the investor relations section of our website. On a non- GAAP basis, gross margin for the third quarter was 46% at the high end of our outlook range, and 160 basis points higher than the 44.4% non-GAAP gross margin in Q2. As mentioned, third quarter revenue by segment end market was very similar to the second quarter, and most of the improvement in gross margins approximately two thirds of it as a result of a more favorable product mix within the specific markets.

Our probe cards segment gross margin was 45.1% in the third quarter, an increase of 180 basis points compared to 43.3% in Q2, the increase is mainly due to their more favorable mix I just mentioned. Our Q3 system segment gross margin was 60%, 90 basis points higher than in the second quarter. As we have said previously, we expect our system segment gross margin to range between the high 40s to low 50s. Gross margin remains an area of focus for us. And we're encouraged by our progress towards our target financial model gross margin of 47%. As a reminder, we expect that margins will fluctuate from quarter-to-quarter, mainly as a result of changes in product mix.

Our GAAP operating expenses were $57 million for the third quarter, $1 million higher than in the second quarter. Non-GAAP operating expenses for the third quarter were $48.5 million or 25.5% of revenues, essentially flat with $48.4 million or 25.7% of revenues in Q2. Company non cash expenses for the third quarter included $7.9 million for stock based compensation, $2.5 million for the amortization of acquisition related intangibles, and depreciation of $6.6 million. Amortization for acquisition related intangibles decreased from $7.1 million in the second quarter, as certain assets became fully amortized during Q2. The increase of depreciation from $6.6 million in Q2 reflects additional assets based and service as part of our capacity expenses. As disclosed in an 8-K filed last month, we adopted restructuring plans during the third quarter to streamline and improve the efficiency and business effectiveness of our operations.

We are consolidating certain manufacturing facilities, including moving operations into our new Livermore Manufacturing Center that will begin production in the current quarter. We expect these actions will be largely completed by the end of 2020. We estimate that these actions will reduce our cost structure by approximately $3 million to $4 million on an annualized basis once the actions are fully implemented. Non-GAAP operating income for the third quarter was $39 million, $3.8 million higher than in the second quarter. GAAP net income for the third quarter was $20.5 million or $0.26 per fully diluted share compared to $17.9 million or $0.23 for full diluted share in Q2. The non-GAAP effective tax rate for the third quarter was 18.9%, practically the same as the 18.7% in Q2 and within our anticipated non-GAAP effective tax rate for fiscal 2021, 15% to 20%.

As a reminder, our annual cash tax rate is expected to remain at 6% to 8% of non- GAAP pretax income until we fully utilize our remaining US based R&D credit. Third quarter non-GAAP net income was $31.6 million or $0.40 per fully diluted share compared to $28.4 million or $0.36 per fully diluted share in Q2.

Moving to the balance sheet and cash flows. We generated $14 million of free cash flow in the third quarter compared to $16 million in Q2. And we have had total cash and investments of $268 million at the end of the quarter. The third quarter $2 million sequential decrease in free cash flow reflects an increase in capital expenditures. As of the end of the third quarter, we had two term loans remaining on our balance sheet, totaling $27 million. We invested $20 million in capital expenditures during the third quarter compared to $18 million in Q2. These brings our year-to-date CapEx to $51 million, chiefly related to the capacity expansion in our Livermore Manufacturing Center. We continue to make significant investments and capacity in 2021 and is mostly behind us. We're fine tuning the range for forecasted cash CapEx for the full year to $70 million to $80 million from the $70 million to $90 million previously communicated. As a reminder, we expect CapEx to return to 3.5% to 4% of revenues in our target financial model, after we conclude this capacity expansions.

At quarter end, our total cash and investments balance exceeded the debt balance by $241 million, an increase of $11 million from Q2 quarter end. No significant share repurchases were made during the third quarter, and year-to-date we purchased 620,000 shares under our two year $50 million share repurchase plan. This brings our year-to-date share repurchases total to about 0.8% of our outstanding shares. The main purpose of the plan is to offset dilution from stock-based compensation, and at quarter end $26 million remain available for future repurchases.

Turning to fourth quarter non-GAAP outlook. As Mike mentioned, we expect generally strong demand to continue with sequentially higher foundry and logic and systems revenue. These factors result in a Q4 revenue outlook in the range of $192 million to $204 million. Non-GAAP gross margins for the fourth quarter is expected to be in the range of 44% to 47%. At the midpoint of these outlook changes, we expect Q4 operating expenses to be higher than Q3 by $1 million to $2 million, mainly due to increased investment in R&D and higher travel expenses as things start to get back to normal.

Accordingly, non-GAAP earnings per fully diluted share for Q4 is expected to be between $0.37 and $0.45. Reconciliation of our GAAP to non-GAAP Q4 outlook is available on the investor relations section of our website. And in our press release issued today.

With that, let's open the call for questions. Operator?

[Operator]

[Operator Instructions]

Our first question comes from the line of Tom Diffely of D.A. Davidson.

[TomDiffely]

Thank you. Good afternoon and nice results. Mike, just couple of quick questions about the industry and how it relates to probe cards. If we spend, $85 million, $90 million on CapEx this year, what is the timing over the next year that's fully integrated into probe card business for you?

[MikeSlessor]

Yes, it's an interesting question, Tom, and one that we've tried to highlight for people, obviously 2021 is going to be an extremely strong record for wafer fab equipment. And what we've seen over the years is, as those of equipment gets delivered, installed, qualified and then begins to produce designs, there's a two to three quarter lag between those equipment shipments and us seeing probe cards demand. You can imagine it does take customers some degree of time to get the tools in running qualified and be producing the specific designs then require probe cards. And obviously we continue to operate on very short lead times or well within a quarter. So we are, part of the reason for our large capacity investments here in 2021. So that we're ready as all of this WFE comes online and begins producing leading edge designs, we're ready to meet that probe card demand in 2022 and beyond.

[TomDiffely]

Great. And then as a follow up to that, Mike, when you look at the move from say five nanometers to three nanometers or the move from FinFET to get all around. What is the incremental opportunity for probe cards?

[MikeSlessor]

I don't know that there's a really big impact there, Tom. I mean, if we go back in history in foundry and logic as we went from planar to FinFET, it drove up test intensity somewhat at the beginning of that transition, just because there's new DSAT modes that the customers have to understand and drive the yield down. And so they're going to test more and drive more data through the test chain, that's going to require more testers and more probe cards. But in the end of the day asymptotes out, they get pretty good at driving things back down to the standard test levels, I think the more interesting thing that's happening is we're seeing a push towards more wafer test probably associated with advanced packaging where people are trying to get something closer to known good die, before they stick the individual die into these advanced die stacking packages. So maybe less associated with transistor architecture and more associated with a move towards advanced packaging. We do see a bit of a tailwind there.

[TomDiffely]

Okay, great. That's helpful. And then Shai, final question here. When you look at the labor market, how is that impacting you today? I guess, both in light of expanding your facility in Livermore, and also restructuring a few other facilities?

[ShaiShahar]

Yes, it's true that we see some delays in hiring and vacancy usually longer. You can see that by looking at our office for Q3, right? We expect it to be a little higher than it came in. But we do something we keep an eye on, and we think we can manage it. We see this labor shortages coming to better results as we get into Q4. We already have more people on boards one month into the quarter. So that's encouraging, and we are on schedule to open our start production in our Livermore Manufacturing Center this quarter.

[Operator]

Our next question comes from the line of Brian Chin of Stifel.

[BrianChin]

Hi, there. Good afternoon, nice results. And thanks for letting us ask a few questions. Off the nice gross margin print here in 3Q and comparable I guess guidance for 4Q, understand that there's costs and labor headwinds that might persist into next year. But also assuming that revenue maintains or progresses from 4Q levels. And maybe the next kind of even reaching in terms of logic foundry, what would hamper you from continuing to operate in sort of the upper half of a 44% to 47% gross margin range, not every quarter basis, but at least averaging out to that over a full year.

[ShaiShahar]

So as we said in fewer earnings calls the biggest factor, the factor that impacts the most our gross margin is product mix. We are running along this trend line, as Mike mentioned in the call towards our 47% gross margin as a target model. But as we make progress towards that goal, we can say things fluctuate along that line. We saw it in Q3 was 46%. When we look at Q4 outlook revenues, at least at the midpoint are higher than Q3, but gross margin mid point is lower than the actual gross margin for Q3 and because of that mix. So that phenomenon, I think will stay with us as we continue to make progress towards 47%.

[BrianChin]

Okay, thanks. And early this morning, Teradyne reference, I think a 25% increase in test intensity for heterogeneous chiplet tile packaging relative to comparable monolithic IC see. Mike, I think that's within range, maybe even toward the high side of what you've talked about previously. So I was wondering how big of a tailwind could this activity represent next year? Do you see broader activity across the handful of key leaders in this space? And does that add any basis points of growth on top of the revenue CAGR? As you've talked about at last year's analysts meeting?

[MikeSlessor]

Yes. So maybe start with the second part of the question. First, if you look back at some of the underlying assumptions that went into the target model that gets us to $850 million in about 2023. Advanced packaging and die stacking heterogeneous integration are a very prominent driver to get us to that model. So when we think about the growth rates that get us there in 2023, they largely are incorporated. But as you know we are seeing some pretty prominent leaders in the industry shift their roadmaps towards these heterogeneous integration techniques. Our largest customers been very clear that they've got a major client processor coming out that this is going to feature this architecture. And is that drives up test intensity at least initially you are going to see some potential tailwinds. But I think at the top level, we had contemplated these factors in our revenue growth assumptions that get us to $850 million in 2023.

[BrianChin]

Great, that's helpful. And maybe just was wondering, could you take a stab maybe at if you double or even triple the transistor count on one of today's sort of leading SOCs, what kind of proportional or not increasing test times you think we're talking about?

[MikeSlessor]

Yes, I mean, test time doesn't scale, as you might imagine, linearly with transistor count. There's all kinds of interesting test technologies that allow customers to make sure there's not a one to one correspondence to that. But going back maybe to Tom's question, the bigger thing rather than transistor architecture transistor count, is people trying to drive more and more test content to the wafer level in the die level, so that when they put the die in these advanced packages, they have a pretty high probability of making sure they're good. You can imagine a scenario in an eight die stack, where if one of those eight die is bad, and you don't have the rework, or redundancy available, that's a pretty good yield. And so that's the fundamental economics that are driving up test intensity associated with heterogeneous integration and advanced packages.

[Operator]

Our next question comes from Craig Ellis of B. Riley Securities.

[CraigEllis]

Great and congratulations on the nice execution and the nice outlook. Mike, I wanted to start just by getting some clarification on the Livermore facility. So one, I believe the press release and your comments indicated that it would be ramping in the fourth quarter. But is it ramping for revenues? And is the revenue associated with that ramp? The growth that we're seeing sequentially in the business or are just a part of that growth? I guess it would be a part because you also said that systems is going to be a quarter-and-quarter.

[MikeSlessor]

Yes, it's a pretty modest contributor to the overall midpoint revenue outlook. But I think it is significant that we are bringing it online on schedule, relaxing what's been a pretty significant or removing what's been a pretty significant constraint for us. We think about this in three components. The footprint we have, the installed tool capacities that we have, and then finally the labor in our factories. And for those of you that have been following us for a while you know we've been footprint constraints. So bringing this facility online, powering it up, getting tools installed, as we're doing now, really relaxes that major, long lead time constrained that we've been operating under. There's other capacity expansions going on worldwide, one of them in our RF line where we continue to see increasing business associated with the 5G DRAM. So there's other components too, I'd say a modest, a little bit of the uplift in the sequential growth, Q3 to Q4 is associated with the new facility. But the potential is a much more exciting opportunity for us.

[CraigEllis]

Got it. And on that RF point, you mentioned that RF was particularly robust, it is that RF front end for 5G smartphones, and is that the move from more high end smartphones over the first year one and year two of shipments to next year's move more into the mid range. And I know we've got a number of Android releases that are coming in the first quarter. And there's quite a bit of excitement about some new base band product for those. Is that what you're seeing? Are you seeing things related to 5G that might be Wi Fi related customer premise equipment, that type of thing Wi Fi 6 et cetera?

[MikeSlessor]

No, I think it's -- there is some Wi Fi 6 elements to it. But I really think the strength is being driven by 5G handsets. Both the growth associated with 5G handsets. But probably more importantly, from a test perspective, the content growth in an RF front end in a 5G handset really pretty significant. If you look at the components and functionality in a 5G handset, the RF front end of a 5G handset, you've got a whole bunch of new components compared to a 4G handset. And of course, you're operating in many cases that significantly higher frequencies up to millimeter wave frequencies which drives up the test complexity. So to answer your question, I don't think a lot of it's Wi Fi six, some of it really is a handset dynamic that's driving RF growth.

[CraigEllis]

Lastly for me, and at the risk of admonishment versus the two question guidelines, could you just talk a little bit more about the systems business? I thought that $35 million a quarter was a very robust quarter for the business. But it looks like it's growing above that. So as we look at the different pieces of that business, you mentioned FRT, but there are others. Can you talk a little bit more about what's happening there, Mike?

[MikeSlessor]

Yes. And so the system segment, you can really think our current data is broken down into three pieces. One is the legacy systems business that we acquired as part of the Cascade Microtech acquisition. And that was a business that both under Cascade's umbrella and ours kind of a low single digit grower serving R&D labs, characterization, failure analysis, things like that. But we've added two of our recent acquisitions to the system segment, one being FRT. And I mentioned the robust adoption, we're beginning to see, especially in the foundry ecosystem associated with the advanced packaging metrology applications that FRT serves. That's been a really nice growth driver for that segment. And the other piece is our acquisition almost exactly a year ago of HPD to get us into the quantum computing test space. So this is test and infrastructure for enabling all of the providers of quantum computers. And there's a long list of companies beginning to commercialize useful quantum computers for some really interesting applications. We're helping them with the test and measurement applications associated with that as that industry begins to grow. So as we look at the system segment, which a couple of years ago was $25 million a quarter, adding on these two other components, FRT and HPD, which are both growing faster, but also adding the revenue to it, it is the primary reason for us getting up to the mid-30s. And hopefully, the high 30s in the near term.

[Operator]

Our next question comes from David Dooley of Steelhead.

[DavidDooley]

Yes, thanks for taking my questions. You mentioned that you had a nice improvement sequentially in gross margins. I was just curious, I'm sure there was still some supply constraints margin impact and higher freight costs. Could you perhaps help us understand how much is still dragging there with freight and supply issues?

[ShaiShahar]

Actually, the supply, go ahead Mike.

[MikeSlessor]

No, go ahead Shai.

[ShaiShahar]

So actually, we didn't see a big impact from increased in shipments costs and things like that for our gross margin. It is -- by the nature of our products, the way we ship them to terms with the customers, this doesn't have a big impact, and it didn't have a big impact on our gross margin in Q3, and we don't think it's going to be significant in Q4 as well.

[DavidDooley]

And I know it probably wasn't very meaningful, was there some revenue impact?

[ShaiShahar]

And no, not at all, pretty small. Sometimes you can have a big probe cards waiting to be shipped because it's missing a small component, but it's really minor so far, really stage up by operation.

[DavidDooley]

Yes. And then as far as the FRT business, could you help us understand how big a segment of business or how big this market is? And what exactly are you measuring in the Advanced packages? You gave some description, if you could just dig in a little bit deeper, that would be great.

[MikeSlessor]

Yes, well, why don't we start with the application space, I mean, there's a variety of new measurements that need to be made on these chiplets primarily at the interfaces between the adjacent chiplet. So you can imagine if you're taking two of these chips and stacking them together, you want to make sure that the connections typically solder bumps or copper pillars are reasonably planar flap that there's no defects things like that. And so the measurement, a rapid amount of planarity of those surfaces, and things like bow and warp, very important for maintaining assembly yields in these brand new chiplet applications. So a lot of our measurements are associated with that, the interfaces between chiplets before they're assembled together. Now because this is an emerging application is difficult to sized market. I think we looked at it is overall probably from a Tam perspective at total available market of a couple of $100 million. That's a fairly wide swathe across all possible advanced packaging apps. And there's a variety of different competitors and alternatives that are probably going to divide up the different sub segments and sub applications. As you know, standard semiconductor applications have been so I think $150 million, $200 million probably a reasonable placeholder for a total available market. It'll obviously from these levels, take us a while to grow into that. But we're really excited about the progress from the FRT team so far.

[Operator]

Our next question comes from Kris Sankar of Cowen and Company.

[StephenChin]

Hi, thanks for taking my questions. This is Stephen calling on behalf of Krish. First question, maybe for Shai. If I could dig in a little bit more on the gross margin in the quarter and as part of the guidance for your probe cards revenues were flat compared to prior quarters that you guys had pretty nice margin expansion there. Was that more of a function of approximately a better product mix within your foundries customer segment or did you also see some material margin expansion within the memory customer segment as well?

[ShaiShahar]

You are not very clear on the -- just the quality of the line. And can you repeat that at least part of it?

[StephenChin]

Yes, sorry for that. Can you hear me better now?

[ShaiShahar]

Yes, that's better.

[StephenChin]

Okay. Great. Yes, the question was on your gross margin expansion within the probe cards segment in Q3 and for the implications about Q4 margin expansion as well. So your foundry and memory customer mix were relatively flat sequentially between Q2 and Q3. So just curious if the most of the gross margin expansion within the probe cards business in Q3, if that was primarily from foundry or did you see a meaningful amount of margin expansion from memory customers as well.

[ShaiShahar]

Yes, so in Q3, it was both our segment had better margin, if you look into Q4, so actually, the midpoint of the output range for gross margin in Q4 is below the 46%, right? It's 45.5%. And the main contributor goes back to what we said in our prepared remarks about product mix within this specific market. So it's true that traditionally systems and then foundry and logic has higher margins, than DRAM and than Flash. But first of all, there is overlap between them. You can have high end DRAM design that has a better margin than foundry and logic design. And you can certainly have within the DRAM market two designs with completely different market, different margins. So as we look into Q4, what we see is we expect less stable product mix within the markets, within foundry and logic, within DRAM et cetera and not necessarily between the markets.

[StephenChin]

Got you. Thank you for that. And as for my follow up, question on your larger Korean customer in your quarter. So imagine most of the business, there's probe cards on the memory side. But can you talk about any potential opportunities longer term within their foundry business, as well?

[MikeSlessor]

Yes, they were, as you know, the 10% customer in Q3, and I believe they were 10% customer in the second quarter as well. In Q3, there was a pretty strong contribution from their foundry business as well. And that's probably the only customer worldwide where we have a significant DRAM business and a significant foundry and logic business, not to mention the systems business as well. So they've been a customer of us on the probe cards side and foundry and logic for many years. There is I think, as they grow their capability and capacity in competing for fabless customers, I do think there's an opportunity there, probably not much of a share gain opportunity, because we feel like we do have reasonably high native share with that customer and a strong relationship across both the DRAM and foundry and logic businesses. But as we talked about some of the other customers making big capacity investments this year, they're certainly in that group. And so as they expand the foundry and logic business, we would expect to grow with that.

[Operator]

Our next question comes from Charles Shi of Needham and Company.

[CharlesShi]

Good afternoon, Mike and Shai. Thanks for taking my question. So first, I want to really congratulate FormFactor team for strong execution on gross margin. Looks like not only your Q3 overall margins backup, but that the appropriate side is retaking the 45%. Really, congratulations on that. So I want to ask a little bit longer term questions. I want to talk about asking you about market share. Obviously, we know where you are strong, you're very strong with a leading IDM on the microprocessor side, you have very strong position in on the foundry side with a good exposure to the mobile SoC side. Maybe let me start with microprocessor, obviously the leading IDM with aggressive turnaround effort, it's becoming very interesting for us to really watch the competitive dynamics between them and the other microprocessor provider. Obviously, that's a fabless customer, but you may have some indirect exposure there. I want to really ask you in that space with the market shares puts and takes what is your high level view on the potential tailwinds or either or headwinds in the context of that data competition between those two microprocessor providers? And how would that potentially changing market share could affect your microprocessor probe cards business either favorably or unfavorably? Then I have a follow up.

[MikeSlessor]

Okay. Yes. As you know, we obviously have strong share at the leading microprocessor manufacturer, but the fabless microprocessor manufacturer has obviously posted some very impressive growth numbers over the last little while, which haven't gone unnoticed by us. Our native share is lower there, our market share is lower there for a variety of reasons, but because it's lower, and because they are gaining share, we've got a pretty strong initiative to go raise that share at the fabless microprocessor customer. So right now being candid with you, if the share were to shift one to one that would be a net headwind for us, that would be a net loss for us. But it's been an area where we've been focusing on and we got good traction. And I think, consistent with our long-term strategy of being a leading supplier at all the leading customers around the world, I think we're in a reasonable position to rectify that. Some interesting subtleties with that business where they won't necessarily use the foundries test services but actually manage themselves. So in that case, they're actually have fabless direct customer, which not to complicate things too much is one of the interesting subtleties of this business.

[CharlesShi]

Thanks for that great color, Mike. Maybe I want to turn to the mic -- mobile SoC processes side. It's been quite topical that one of the Chinese smartphone maker reportedly is working to bring the apps process of design back in-house, maybe starting from three nanometer. I think this is the move kind of reflects the continued evolution of like all those assistant companies coming in, take designs in- house. And maybe there's a headwind for one of your indirect foundry customer in the mobile space, a US company there. I wonder what FormFactor thinks in terms of the potential landscape shift also in the mobile SoC space in particular, I mean, when the system companies, they tend to favor one leading foundry over the other where you may have a little bit stronger position there. Could you give us a little bit more color on that? Thank you.

[MikeSlessor]

Yes, I mean, I think that's this trend in sourcing and more vertical integration with our customers is an interesting one. And it it's not new, right? The hyperscalars have been taking design in-house, obviously the large handset manufacturer continues to take more inside and almost becoming their own silicone company, their own fabless company. This again goes back to similar comments I made about the microprocessor situation where it's one of the reasons why we want to make sure we have strong share positions and strong relationships at all of the leading foundries and with all the leading fabless customers because many of these fabless customers actually manage their design and test operations themselves and don't outsource them to the family so creates a more complicated account management structure. But again, I point back to really making sure that we as a company are engaged. And I think we're pretty well engaged with all of the leading fabless and foundry customers, so that the shifts in their manufacturing strategies and sourcing strategies end up being net neutral for us.

[Operator]

Our next question comes from Christian Schwab of Craig-Hallum.

[TylerBurmeister]

Hey, this is Tyler on for Christian. Thanks for let us ask some questions and congrats on the solid quarter. I want to ask about your DRAM probe cards business including your kind of implied Q4 guidance of flat, 2021 is going to be a pretty strong growth year. So I'm just wondering, is there really any reason we should be suspect about this strength continue to 2022 year, you're serving all customers and there's going to be continued design and no transitions next year? So I'm just wondering if there's any reason that the string shouldn't continue?

[MikeSlessor]

Yes, good question. As you might imagine a topic of pretty significant internal debate. I think one of the things to remember is history has taught us that DRAM probe cards, like all DRAM supply chain elements are a cyclical business. For the past couple of quarters and we expect here in the current fourth quarter kind of to be at the historical high end, high $30 million low $40 million quarterly DRAM probe cards revenue, which is above sort of the mid-30s, that we've talked about being the average normalized level, the fundamental drivers for that, as you note are continued no transitions and design releases. And as long as those continue in the customer base I don't see any reason why at least a mid-30s assumption is not a reasonable one, we are a little bit surprised that we've got now two quarters in a row in the books and one quarter looking at the current one sort of hovering around that $40 million level, which represents the all time record quarter, I think, at $42.5 million or $43 million. So we're operating pretty close to all time record levels in DRAM, given the historic cyclicality that might be a little surprising. But the fundamental constituents that drive that demand, they're still there. And I think we're executing pretty well in DRAM. I think we've probably gained share here in 2020.

[TylerBurmeister]

That's great. Appreciate that color. And then second question, kind of on the supply chain, it sounds like you guys are executing well, and not seeing a material impacts to yourself. But I think you made the comment that you do expect the environment to persist in the next year. And presumably that's coming from conversations you're having with customers. So I'm just wondering if there might actually be a benefit to this environment, further conversations with your customers at least benefiting you from a visibility standpoint. Any comments there on supply chain impacts would be great.

[MikeSlessor]

Yes, I mean, the supply chain issues have been really kind of interesting. And ironically, many of them have the root cause back in the semiconductor shortage. So where we've had challenges with subsystems or sub components that are not vertically integrated, they really have been associated with some isolated chip shortage. I don't think it's improving visibility all that much. I mean we're still running lead times well, within a quarter. But we'd hope that as the capacity comes online associated with all of the different increases in capacity across the industry, especially at the leading edge node to satisfy this shortage that again should be driving pretty solid demand across our different businesses. Part of what we've benefited from, as I mentioned in the prepared remarks is pretty vertically integrated for a tech manufacturing company in the semiconductor ecosystem. And that was not a very fashionable to make several years ago. But we did it for a couple of good reasons. One of them being continuity, and it has paid off here a little bit.

[Operator]

Thank you. At this time, I'd like to turn the call back over to Mike Slessor for closing remarks.

[Mike Slessor, President and Chief Executive Officer]

Great. Thanks everyone for joining us again. We're hopeful to attend a couple of conferences end of the year. I don't know if that be in person or virtual but hope to see you there and thanks for your continued interest in FormFactor. Bye -bye.

[Operator]

And this concludes today's conference call. Thank you for participating You may now disconnect.